Sea Change

By Patrick Donley, Matthew Gutierrez, and Shawn O'Malley, edited by Robert Leonard · December 28, 2022

*LinkedIn newsletter is posted at a one-day delay.

Wall Street strategists have been busy this month publishing their 2023 outlooks, and the results are all over the map.?

Many are calling for a recession, which would make 2023 maybe the most widely forecasted recession ever.???

Regardless, the average forecast expects the S&P 500 will end 2023 at just over 4,000, the most bearish outlook since 1999. However, predictions range from 3,400 to 4,500, representing the widest dispersion since 2009.?

If we learned anything from 2022, it's that nobody knows where markets will move next.?

Here's the rundown:

MARKETS

*All prices as of market close at 4pm EST

Today, we'll discuss two items in the news: New Chatbot spurs "Code Red" at Google and credit market cracks widen, plus our main story on Howard Marks' December memo, Sea Change.

All this, and more, in just?5?minutes to read.

IN THE NEWS

?? New Chatbot Spurs "Code Red" for Google's Search Business (NYT)?

Explained:?

• Three weeks ago, an experimental chatbot called?ChatGPT?revealed itself as, perhaps, the tech industry's next major disruptor. The bot can deliver clear, unique responses to inquiries in simple sentences.?
• From business strategies to Christmas gift suggestions, the bot has proven capable of generating ideas from scratch while concisely explaining complex topics. In response to its release, Google's (GOOGL) management, which has seen its business serve as the primary gateway to the internet globally for two decades, declared a "code red."?
• Because these systems work by analyzing huge swathes of data across the internet, their responses can be distorted by biases, toxic language, and an inability to distinguish fact from fiction. While Google has hesitated to deploy these technologies, which could cause scandal and damage its brand, newer competitors are less cautious.?

Why it matters:?

• Assuming Google can perfect its chatbots to fend off competition in the space, these bots may cannibalize the company's lucrative search business by providing people answers directly rather than presenting a page of relevant links with the opportunity to embed advertisements (as it currently does).?
• Google must consider overhauling its iconic search engine with advanced chatbots while trying to mitigate harm to users or society.?
• In the meantime, Google has used its A.I. chatbot tech to improve its existing search engine by enabling it to better interpret users' searches.

???Credit Market Cracks Widen as Distressed Debt Nears $650 Billion (Bloomberg)

Explained:?

• After years of excesses, stress points are emerging in credit markets, according to Bloomberg. From banks stuck with buyout debt and a pension blow-up in the U.K. to real estate troubles in China and South Korea, the picture is only getting uglier. Distressed debt has increased in the U.S. alone by more than 300% in the last twelve months while corporate debt ratios hit new records.
• With the Fed pushing up interest rates and tilting the economy towards a recession, upended credit markets have seen the value of outstanding loans and bonds considered distressed rise to nearly $650 billion.?
• One strategist at UBS suggested that default rates could hit 9% next year if the Fed maintains its aggressive monetary-policy path. That would be the highest level since the 2008 financial crisis.?
• At the same time, investor protections, known as covenants, have weakened in recent years. In other words, it was easier to borrow without as many restrictions on how funds could be used.

Why it matters:?

• A deep recession could cause significant credit crises, according to Paul Singer's Elliott Management Corp., which argued that the global financial system is "vastly over-leveraged."
• "It's all adding up to the biggest test of the robustness of corporate credit since the financial crisis and may be the spark for a wave of defaults," said Bloomberg. Banks have begun setting aside money to offset missed payments and defaults, with loan-loss provisions rising 75% year-over-year last quarter at systemically important banks.
• Additionally, while banks expected to quickly offload buyout-related debts, such as the $40 billion used to fund Elon Musk's takeover of Twitter, investors' appetites to take on these risky debts have largely evaporated.?

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THE MAIN STORY: SEA CHANGE

Overview

A new Howard Marks memo is out this month that's making the rounds among the investment community.?

When Marks drops a memo, people take notice. His notes are closely followed by over 200,000 investors.

One reader is Warren Buffett, who has said: "When I see memos from Howard Marks in my mail, they're the first thing I open and read. I always learn something, and that goes double for his book."

Marks, 76, is Oaktree Capital Management's Co-Chairman, with a net worth of about $2.2 billion. He published his first memo in 1990, when only 50 clients read it. In the decades since, he's periodically released memos reflecting his viewpoint on investing, plus general business insights.?

His latest is titled?"Sea Change." The short summary: Risk aversion and higher rates are embedded in the current environment, and the implications are substantial.?

Let's dive in.

A world of less risk?

Marks isn't known for hyperbole or grandiose predictions. He speaks with intention and writes only what he means.?

Marks explains that the investment world may be experiencing the third major "sea change" of the last 50 years. In recent years, especially amidst the spike in inflation and the Federal Reserve's response, the market conditions that prevailed during the post-GFC (Global Financial Crisis) period and for much of the last four decades are seemingly reversing.?

He discusses what this potentially new era could mean for lenders, particularly bargain hunters. He sees a sea change coming with persistently higher interest rates and chronic inflation, resulting in less risk-taking for the foreseeable future.?

After the Covid bubble made meme stocks, SPACs and tech stocks in vogue, Marks writes that he's observing a noticeable shift in the global environment. He believes we've reached the end of the era of falling interest rates, which has spanned most investors' entire careers.?

"Investors can now potentially get solid returns from credit instruments, meaning they no longer have to rely on riskier investments to achieve their overall return targets," Marks wrote.?

The investing world will be "different from what it was over the last 13 years and most of the last 40 years," he continued. "It should follow that the investment strategies that worked best over those periods may not be the ones that outperform in the years ahead."

Higher rates in store

Marks gave a historical overview of the two sea changes he's witnessed in his career, which began in 1969, after graduating from the University of Pennsylvania and working at what is now Citigroup as a stock analyst.?

The first sea change was the introduction of risk management into conventional investing 50 years ago, the advent of junk bonds, private equity, and other new financial opportunities. The second sea change arrived with a (mostly) four-decade run of falling rates, propelling risk-taking.?

With the third sea change, he wrote: "Things will be less rosy."

He says the beneficiaries of this switch will be lenders and bargain hunters, which includes bondholders and value investors.?

Marks is a value stock player who also forays into credit markets. He has said, "The short run is by far the least important thing," and it's unwise to predict what will happen to interest rates or inflation.

Nevertheless, he believes the benchmark interest rate will be in the 2% to 4% range for the next several years, not far from where it is, compared with the sub-2% standard of recent years.?

"The bottom line is that highly simulative rates are likely not in the cards for the next several years, barring a serious recession from which we need rescuing (and that would have ramifications on its own)" Marks wrote.

The significance of falling rates?

Another section of the memo resonates with us:

• "What are the factors that gave rise to investors' success over the last 40 years? We saw major contributions from (a) the economic growth and preeminence of the US.; (b) the incredible performance of our greatest companies; (c) gains in technology, productivity, and management techniques; and (d) the benefits of globalization. However, I'd be surprised if 40 years of declining interest rates didn't play the greatest role of all."

Many hope he's wrong, and so does Marks.?

What we know is that change is inevitable, a concept Marks took to heart after he minored in Japanese at the Wharton School. He learned the concept of mujo, a word originating in Buddhism, meaning impermanence and the inevitably of change.?

To Marks, big change might be coming.?

Dive Deeper

If you haven't yet, check out?our summary?of his November memo, "What Really Matters?"

Here's our interview with Marks on?We Study Billionares?from 2021.?

And here's where you can access the?full library?of Marks' writings.

Happy reading!

SEE YOU NEXT TIME!

That's it for today on?We Study Markets!?

See you later!

All the best,

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